Flexible Inflation Targeting (FIT) Framework in India

Source: TH

Context:

Introduced in 2016, FIT provides a forward-looking monetary policy mandate for the Reserve Bank of India (RBI) to maintain inflation at 4% ± 2%. The current FIT cycle is ending in March 2026; the RBI is reviewing the framework for the next five years (up to 2030–31).

Objective: Maintain price stability, protect the poor, encourage savings and investments, and support sustainable economic growth.

What Is FIT?

The Flexible Inflation Targeting (FIT) framework is India’s modern monetary policy system, introduced in 2016 through amendments to the RBI Act, 1934. It gives the Reserve Bank of India (RBI) and the Monetary Policy Committee (MPC) a clear, forward-looking mandate to maintain price stability while supporting economic growth.

Why Was FIT Introduced?

1. To curb persistently high inflation (2008–2014 period).
2. To move India towards modern, rule-based monetary policy.
3. To improve transparency and accountability of RBI.
4. To formally institutionalize the MPC.

Key Questions in FIT Review

• Headline vs. Core Inflation Targeting
  • Headline inflation includes food and fuel; core inflation excludes them.
  • Rangarajan argues headline inflation should be targeted:
    • Food inflation is not solely due to supply shocks—it can affect general price levels through second-round effects like wage increases.
    • Aggregate liquidity expansion is key: without it, food price changes only affect relative prices, not overall inflation.
  • Effective monetary policy in India must consider food inflation due to its broader impact on core inflation and overall price levels.
• Acceptable Level of Inflation
  • Using historical data and growth-inflation relationships:
    • The threshold or inflection point for inflation in India is around 4%.
    • Low inflation (below 4%) can support growth, but higher inflation negatively impacts savings, investment, and growth.
  • Implication: FIT should continue to target around 4%, with very limited justification for a higher target.
• Inflation Band
  • Current band: 4% ± 2% (i.e., 2%–6%).
  • Provides flexibility for monetary authorities to respond to shocks.
  • Concerns:
    • Staying close to the upper limit (6%) for prolonged periods could defeat FIT’s purpose.
    • High inflation (above 6%) historically correlates with lower growth.

Key Considerations for FIT and Macroeconomic Stability

• Fiscal-Monetary Coordination:
  • High inflation in the 1970s–1980s was linked to fiscal deficit monetisation.
  • FIT works best alongside Fiscal Responsibility and Budget Management (FRBM) Act provisions.
• Policy Implications:
  • Forward-looking approach: monetary policy must align with projected fiscal and external pressures.
  • FIT provides a flexible yet disciplined framework for maintaining price stability while supporting growth.